Tax Cuts Under Price Controls

Yesterday I was explaining Singapore's clever approach to fiscal stimulus to Russ Roberts at lunch. During the explanation, I realized that I should probably back up and explain how tax cuts works in markets with price controls. But since I was feeling a bit sick, I didn't have the energy.

Hopefully Russ will consider this a make-up assignment. Here goes:

With flexible prices, of course, we have the standard result that de jure responsibility for a tax has nothing to do with de facto incidence. Inelastic factors reap the benefits of tax cuts; elastic factors don't.

But what if a market has a persistent surplus due to a price floor? Then de jure responsibility matters a lot. If you cut the tax paid by suppliers, the surplus actually gets bigger. Getting the legal minimum with low taxes is even better than getting the legal minimum with high taxes.

In contrast, if you cut the tax paid by demanders, the surplus gets smaller. Paying the legal minimum plus low taxes is less onerous than paying the legal minimum plus higher taxes. If you cut the tax enough, you might be able to eliminate the surplus entirely.

You could object: "What does this have to do with unemployment in Singapore? They don't have an economy-wide wage floor, do they?" Of course not. But unless Singaporeans are psychologically very different from almost everyone else on earth, they resent nominal wage cuts. And the analysis above does not fundamentally change if the "price control" stems from psychology rather than an act of government. If workers are unemployed due to excessive wages, and if for some reason wages do not fall, you can get around the problem by cutting the taxes paid by employers. Which is precisely what Singapore does.

Blogging software: Powered by Movable Type 4.2.1.
Pictures courtesy of the authors.
All opinions expressed on EconLog reflect those of the author or individual commenters, and do
not necessarily represent the views or positions of the Library of
Economics and Liberty (Econlib) website or its owner, Liberty Fund,
Inc.

The cuneiform inscription in the Liberty Fund logo is the
earliest-known written appearance of the word
"freedom" (amagi), or "liberty." It
is taken from a clay document written about 2300 B.C. in the Sumerian city-state of Lagash.